...The model’s estimates show that while all three measures of relative economic conditions are significant determinants of migration, the magnitude of their impact varies. The estimates also show that the impact of these economic factors on state-to-state migration flows has changed considerably over time. For example, the importance of per capita income as a determining factor has fallen considerably since the late 1970s, while that of housing affordability has risen.

I'll get back to that. From page 1:

Although the region’s unemployment rate was below the national rate as of May, New England had not recovered all of the jobs it lost during the 2001 recession before entering the current economic downturn, largely because of sluggish employment growth in Massachusetts (see Figure 1). At the same time, real house prices jumped 50 percent in New England between 2000 and 2005, compared with an increase of only 33 percent nationwide (see Figure 2). Moreover, household incomes did not keep pace with the run-up in house prices, causing housing affordability to decrease during this period in every New England state (Sasser, Zhao, and Rollins 2006).

Throughout the paper, they do this weird economist thing where they route the causality of constricted housing through prices and elasticities. In some ways, I am sure that helps to think about things properly. But, if there is a hamlet with 20 houses renting for $1,000, and 5 years later, the hamlet still has 20 houses, now renting for $1,500, it seems strange to me to think about it in terms of price. There were 20 households there before and there are 20 households there now, because households need a house. The change in price is a reflection of other factors. Generally, they reach the same conclusion either way. Housing constrictions have become the bottleneck in most of New England. But, I think this way of thinking about the effects of housing through elasticities instead of simply through supply may create more heat than light. If Boston adds enough housing to add 100,000 new workers, normal employment levels will rise by roughly 100,000. They seem to be thinking about causality as:

I think the elasticity that is important here is the elasticity of demand for labor services that gain an advantage by being located in Boston. Thinking about it this way also makes it more clear how deeply local self interest would cut against any solution to the problem - even if that self interest is intuitive. Heck, even if intuitions are completely off base about this, simply the causation of a housing solution leading, invariably, to lower local incomes, will create political pressures against it. If a local political faction institutes a broad set of policies that include a housing solution, they may be run out of office when incomes start to drop, even if not a single voter understands that falling incomes are a necessary part of a housing solution that makes the city livable for middle income families.

Here is a line I will quibble with a bit (also from page 1):

If greater out-migration from New England is related to high housing costs that stem from excessively restrictive zoning regulations, then policymakers might consider expanding the use of statutes such as Massachusetts’s 40B, 40R, and 40S, which require or encourage the building of affordable housing.

This is kind of the nub of the problem. This statement would be inordinately more true with the removal of the word "affordable". In fact, with the word "affordable" it may not be true at all. I expect there is a nearly perfect negative correlation between cities with "affordable" housing statutes and cities with affordable housing. Likewise, a nearly perfect positive correlation between cities that encourage affordable housing and cities with affordable housing.

Page 3:

During the 2001 recession, the net number of individuals leaving the region increased as expected, yet the exodus continued to accelerate through 2005, reversing course only recently (KE: 2009).

That reversal is likely due to increased utilization of the housing stock because there is little building in the rest of the country. Since the constraints to building in Closed Access cities are regulatory and since those constraints maintain the value of land that is approved for development well above its alternative uses, the constraints created by national policies since the crisis have had a much more devastating effect on building in Open Access cities than they have in Closed Access cities. Ironically, even though everyone was concerned about housing affordability, the policies we have imposed only continue to undercut homebuilding in the most affordable places. Those also happen to be the places where the supposedly irrationally exuberant homebuyers were building before we imposed macro-prudence on them after 2005.

This explains the strange divergence of average new home prices from existing home prices and the subsequent convergence. Seeing the housing boom from a credit-side perspective, it might have seemed as though the relative decline of new home prices was the result of an influx of many low income borrowers. But, there weren't an influx of low income borrowers, in the aggregate. This divergence was a product of location. There are several ramifications of this. I'll go into this some more in another post.

In this post, I want to go back to the finding in the paper from the Boston Fed. They found that migration flows were sensitive to incomes in the late 1970s and 1980s, but that in more recent years, housing affordability has become more important while income has become less important.

But, I think this poses a problem, because the defining characteristic of the period since 1995 is that there is a small subset of cities which have become extreme outliers in both incomes and housing affordability. In prior periods, higher incomes would induce in-migration, which would induce housing expansion. In that regime, incomes would correlate with in-migration.

But, in the housing-constrained regime, higher incomes induce in-migration, which induces rent inflation. So, this paper appears to measure a small in-migration effect from higher incomes and a small out-migration effect from higher home prices.

I think there is probably a more useful way to look at this. Here is a table of estimated effects from Unemployment, Income, and Housing Affordability, from the paper:

I hope this is readable for you. The column on the far right estimates the effect, in thousands of residents, of a one standard deviation change in the factor. The proxy for unemployment is unemployment insurance claims.

From 1977 to 1986, a rise in local unemployment led to out-migration of 209,000 residents, a rise in local income led to in-migration of 789,000 residents. Housing affordability had negligible effects.

By the 1987 to 1996 period, the unemployment effect remained similar, but now the income effect was small, and there was a small countervailing housing affordability effect.

By 1997 to 2006, a rise in local unemployment appeared to lead to out-migration of 69,000 residents, a rise in local income appeared to lead to in-migration of 32,000 residents and a rise in home prices appeared to lead to an out-migration of 89,000 residents.

I think the way to look at this is that housing supply is largely unresponsive to demand. So, net relative migration from these factors is forced to zero. The early period represents the effect of employment and income on migration flows in an Open Access setting (or something resembling that). I think the measures should be taken as constants for the later period. The net out-migration of 69,000 residents due to rising local unemployment may be the net effect of falling employment prospects mitigated by falling home prices. We might think of it as out-migration of about 269,000 residents due to employment shocks and an in-migration or retention of about 200,000 residents because of the directly related relief in housing affordability.

Similarly, rising incomes in the later period might draw about 750,000 residents to the area, but since the area can't take more residents, this leads to higher housing expenses, until about 700,000 residents out-migrate.

It may be that gross coefficient of migration induced by higher incomes that is the most informative. In 1979, the median income in Boston was about 9% above the US median. By 1995, it was 27% above, and in 2015 it was 42% higher. In 1995, Median Income net of Median Rent in Boston was 24% higher than the US median. By 2015, it had grown to 33% of the US median. The median household in Boston has only kept about half of their relative income gains since 1995, and Boston has fared better than the other cities that I call "Closed Access" in this regard.

The question this paper poses, to my mind, is, "In gross terms (without the countervailing influence on migration from the constricted housing supply), how much in-migration was induced by a 30% rise in relative incomes?". That is roughly how much of an increase in housing would be required to make Boston affordable again.

Wednesday, January 27, 2016

Part of the background of my housing project is the importance of real long term interest rates in home valuations. There is some academic literature on this. But, I think in broader discussions of the topic, the effect of interest rates on home prices is assumed to work through mortgage affordability. This is problematic because mortgage rates are nominal rates. Nominal rates are a combination of real rates and an inflation premium. A decline in either might increase home prices, but they operate in different ways. Falling real rates increase the intrinsic value of the home. The effect is such that falling real rates should not, necessarily reduce the affordability of the mortgage. In fact, considering the long life of a home, if home values are fully exposed to interest rate levels the way other securities are, a falling real interest rate might lead to higher mortgage payments, even after factoring in the lower rate.

A falling inflation premium can increase demand by making mortgages more affordable, in nominal terms. When I first started thinking about the housing bubble, this was my assumption. I thought about it through a finance framework, that the obstacle to nominal financing meant homeowners had earned "alpha" in previous times when interest rates had been high. Since both real rates and the inflation premium were low in the 2000s, I thought that what had happened was that more open access to homeownership had reduced "alpha", and that higher prices weren't so much a sign of excess, but a reduction in the benefits that used to accrue to those with access to credit.

Ironically, that is the story today, in 2016. A lack of broad access to mortgage credit means that homeowners are earning significant "alpha" today. But, since first looking at the issue, I have changed my mind. The housing boom wasn't so much the result of more access to credit as it was the combination of access to credit and a lack of access to building. In many valuable areas, homes can't be built, but for those who want to buy them, credit is available. The difference between 2005 and 1995 wasn't so much the access to credit as it was the lack of access to building.

From BEA table 7.12, with home values from Federal Reserves'
Financial Accounts of US (implied by Consumption of Capital before 1950)

Here is a graph of implied returns to owner-occupied homes since 1929. HUD programs had brought home ownership up to the current range by the mid 1960s. Before that, households tended to rent, and owners tended to have very low leverage. Keep in mind that from the Great Depression until at least the mid-1950s, interest rates on treasuries were very low. So, we can see the high returns to homeowners before the Great Depression, but 3% real returns in the 30s and 40s also represent a high relative return.

But, this excess return appears to have been mostly bid away by the mid 1960s by access to ownership that was facilitated by government programs. This graph shows net total returns to homeownership (green line) and the net returns after nominal interest expense (blue line). We can see that once debt financing became widespread, real total net returns remained in the 2.5% to 4% range that long term bonds generally yielded during that time.

One difficulty is that we don't have market rates for real yields on treasuries before the late 1990s. So, especially during the volatile period of the 1970s and 1980s, it is difficult to confirm these trends. But, in the late 50s, early 60s, and 90s, when inflation expectations were calm enough to roughly estimate real rates, real long term rates and implied housing yields appear to have all ranged in the 3.5% to 4% range. So, alpha from homeownership seems to have been capable of being low for some time.

Here is a chart of mortgage affordability, over time, for Houston (an Open Access city) and San Francisco (a Closed Access city). There were already some supply constraints in the San Francisco metro area (MSA) by the late 1970s, and we can see that here. This graph concurs with these intuitions about home values.

First, we can see in the difference between San Francisco and Houston that the effect of Closed Access policies is a stronger force regarding affordability than the effect of either real or nominal interest rates or than credit access, since local policies are the only factor that differs between cities. Second, looking at affordability in the early 1980s, when inflation premiums were very high, we can see that the obstacle of nominal mortgage affordability did not lead so much to lower home prices as it did to higher mortgage payments. If the demand-side effects of nominal mortgage rates were strong, we would see somewhat stable mortgage affordability levels. The decline in mortgage rates from 1982 to 1995 was generally a decline in the inflation premium. (In fact, real rates probably rose during that period.) And, mortgage payments fell roughly in proportion to interest rates. The demand constraint of high nominal payments appears to have had little effect on home prices.

On the other hand, between 1995 and 2005, real interest rates fell by close to 2% while the inflation premium remained fairly stable, or declined slightly. In Houston, this had little effect on mortgage affordability. From 1979 to 1995, falling inflation brought down mortgage payments with little effect on home prices. From 1995 to 2005, falling real rates pushed up home prices with little effect on mortgage payments.

In San Francisco, the operable effect on mortgage affordability during the 1995-2005 period was sharply rising rents. From 1979 to 1995, mortgage affordability followed roughly the same pattern as it followed in Houston, because the primary cause of the decline was the same in both cities - falling inflation premiums on mortgage payments. But, from 1995 to 2005, there was a divergence. The cause of the rising mortgage payments in San Francisco was a local phenomenon, coming from rising rents.

I think it is interesting to compare the 2000s to the late 1970s. In the 2000s, home prices were rising by close to 10% per year, sometimes more. As households kept taking on larger mortgages, observers complained that those gains were unsustainable, and that those households were overspending for their homes based on unrealistic expectations. But, how is this any different than what happened in the 1970s? Home prices were going up just as strongly then. And, homeowners were taking on mortgage payments that were a large portion of their incomes in order to fund them. So, what was the difference between these two periods?

The difference is that the price increases of the 1970s were part of the broader monetary inflation we had at the time. In that period, mortgage rates were high because inflation was imbedded in the interest rate. Since mortgages can be pre-paid, the mortgage terms also had an imbedded hedge against falling inflation.

But in the 2000s, the price increases came from localized supply constraints, and broader monetary inflation was low. So, in the 2000s, the inflation that affected the housing market was not embedded in the mortgage inflation rate, it was embedded in the price of the house. This difference meant that there was not a natural hedge embedded in the mortgage terms that could ratchet down the cost of the mortgage when home rents stopped climbing.

Of course, as I have pointed out, the local constraints that drive up rents are still operable, and the collapse in home prices was something we engineered at the macro level. After 2007, real interest rates collapsed along with home prices and mortgage affordability, which, when we carefully assess the factors involved in home affordability, we can see is the sign of a significant disequilibrium.

But, thinking about the difference between the 2000s and the 1970s, how should we have expected housing markets to behave? Should they have ignored the persistent rent inflation in the high cost cities? That's the thing about markets. They don't ignore things. And, the policies behind those rising rents are much more entrenched and persistent than the inflationary policies of the 1970s. Homebuyers in coastal California and urban New England in the 2000s were at least as justified when they took on those mortgages as the homebuyers in the 1970s were.

The macro-instability inherent in the housing market of the 2000s was fully a product of the local policies that constrained supply. The instability wasn't caused by the homebuyers that were bidding up prices to reflect those constraints. It wasn't, at its base, caused by the banks that were funding those purchases. It was caused by decades of errant policy development in city halls and regional development committees.

Now, it is true that we can curtail lending enough to counter that instability. That is what we are doing now. Creating stability through credit contraction means falling home prices and rising rents. It means the most financially secure 1/3 or 1/2 of households that are able to secure credit or buy with cash earn excess returns on their imputed rent - the rent they avoid by owning. And landlords can earn excess returns through higher rents from tenants who are locked out of homeownership. And, in the way that we have imposed those credit constraints, that applies in Houston as well as San Francisco. That is why (looking back at the first graph) even though homeowners are as leveraged now as they were in the 1990s, they are now earning returns, after interest expenses, as high as homeowners in the 1950s did with much lower leverage.

On the topic of real interest rates, it occurred to me that one proxy for real interest rates is the Equity Risk Premium (ERP). ERP is a measure of the difference between risk free rates and expected returns on equities, and it is a real (as in, without inflation) measure. This is an estimate, not a market price, but it is a measure for returns to another real asset - corporate equities. Since total real expected returns to equities appear to be fairly stable over time, ERP tends to be an inverse measure of real risk free interest rates.

So, I have graphed here, the implied return on housing (orange), the recent market rates on 30 year real bonds (maroon), 20 year nominal treasury rates minus inflation for the years where inflation expectations should have been somewhat close to actual inflation (purple), and the inverted ERP (green). The 20 year rate measure here probably adds more heat than light. The real rate in the late 1960s was probably slightly higher than the rate estimated by the 20 year rate here. But, sometime during the 1970s, real long term rates probably were as low as the inverted ERP implies.

And, the inverted ERP does seem to be a good proxy for real long term interest rates, as they might apply to housing - until the disequilibrium that began after 2007.

The very high ERP and very low 20 year treasury yield (minus inflation) in the 1970's suggest that home yields should have been lower (home prices should have been higher). This is counter evidence to my speculation above that the high inflation wasn't a drag on home prices at the time. Equities were fetching mysteriously high premiums at the time, which could partly be explained by the tax effects of high inflation. Homeowners would be immune from the tax effects on imputed rent, and some of the tax effects on capital gains, so some of the separation of yields in the 1970s could be from those factors. But, maybe the effect of high mortgage payments on demand did keep home prices down and yields up, relative to other assets, during that period.

Tuesday, January 26, 2016

The Economist has a great interactive graph to compare home prices among various countries.

Using their Price/Rent measure as a measure of relative home price appreciation, I recorded the values for each country that had data from 1995 to 2014. This included 17 countries.

Of those 17 countries, 6 have not seen any significant increase in Price/Rent ratios since 1995.

Eight of the 17 had Price/Rent increases of at least 50%, that have are still near their highs, as of 2014. (Ireland is a bit of an extreme case, and they are far off their highs, but they still have Price/Rent levels more than 50% higher than 1995.)

That leaves 3 countries out of 17 - the US, the Netherlands, and Spain - that had Price/Rent increases of more than 50% after 1995 which have since retreated below that level, most of the way back to 1995 levels.

So, if our housing markets had never boomed, we would have had a lot of company. If our housing markets had boomed and remained elevated, we would have had a lot of company. Either of these outcomes reflect conditions which are common in many countries.

But, a bust? That is an anomaly - the US, along with the 16th and the 27th largest economies. If we want to talk about specific national policies that created unique national outcomes, then we need to talk about the bust. If we are going to talk about the boom across the countries that experienced it, there is some combination of low long term real interest rates and a lack of supply response in cities that attract productive workers. It looks like the first question should be, "What policies did we have that kept prices so moderate, compared to most of the other major economies?" And, our answer to that, probably, starts along the lines of, "Households in the US are relatively mobile, and even though sclerotic housing policies are spreading among many cosmopolitan cities across much of the globe, places like Georgia, Texas, and Arizona bucked that trend, and American households were willing to move there in large numbers."

The countries with no booms probably have a mixture of depopulation, liberal housing policies, and tax policies that minimize housing consumption. We could talk about whether those policies could make sense in the US.

But, the one answer that seems like the wrong answer - "US banks, or US federal housing subsidies, pushed us into a housing bubble that was unsustainable." - is such a popular topic that it seems to have created its own bubble in popular non-fiction publishing.

Monday, January 25, 2016

Daniel Thornton has a frustrating piece at Alt-M today. The putative theme of the piece is that the Federal Reserve lacks faith in markets to heal and adjust to changing contexts. That is all well and good. But, the faith in markets Mr. Thornton projects is awfully selective.

He categorizes much of the past 20 years as "bubbles". Apparently Mr. Thornton has a higher opinion of his own pricing calculations than he does of the market's. His complaint is that the Fed was easing - in the spring of 2009! Because, I guess, the one thing that the market can't adjust to, in Mr. Thornton's estimation, is having a bit of money.

He says:

It is impossible to know for sure. But there is little doubt that the Committee failed to recognize that healing takes time. Monetary policy had already eased considerably by March 2009.

Core inflation was 1.8% in March 2009 and fell to 0.6% by October 2010, even with the Fed's belated support in 2009. What would Mr. Thornton had preferred? Maybe if we had had 1% deflation still in late 2010, Mr. Thornton could have comforted us about the delayed benefits of those brief, early 2009 interventions, and the inflationary relief that would soon come.

He says:

This action paved the way for the FOMC’s nearly 8-year zero interest rate policy, which has encouraged risk taking, redistributed income to the wealthy, contributed significantly to the rise in equity and house prices (which have surpassed their previous “bubble” levels), and created considerable uncertainty. If the FOMC had maintained some confidence in markets’ ability to adapt, it would have waited a little longer to act and might have avoided an incredibly long-lived policy that will be extremely difficult to exit.

Oh, you say that your rent has been rising and you can't qualify for a mortgage to buy your own home? Well, please understand, markets are wonderful aggregators of decentralized information. Your rising rent is the market's magical, wonderful way of confirming your state of deprivation. But, you see, the one thing markets can't handle is money. If we let you get your hands on some, you might go out and build a home. And, then, as the esteemed Mr. Thornton could explain to you, you would be insulated from those rising rents. You would be living in a bubble. Markets are God's way of letting Mr. Thornton know that you feel your deprivation honestly.

I wonder what the theory is behind bubbles that don't lead to an increase in quantity. I get the feeling that people like Mr. Thornton are operating with the notion that after a decade of severe, depression level housing starts, we are still working off the excesses of the housing starts of the 2000s. (See that little blip there in the graph, next to that giant, crater of deprivation? That's it. That little blip.) Have they bothered to look at a single graph of housing starts? Have they bothered to even reconcile their housing valuation concerns with the problem that rent inflation is the largest cost-of-living problem we have right now?

So, you say we have a problem that the left in this country doesn't have faith in markets? Show me a single right-wing candidate that has any more faith in markets than Mr. Thornton - including the libertarians - then talk to me.

There is one basic, introductory point that I think stands as a simple response to the volumes of pages that have been written about the housing boom of the 2000s - the mis-named subprime crisis, or housing bubble. With regard to all of the descriptions of fraud, over-confidence, greed, predatory lending and irresponsible borrowing, there is this simple graph.

I have drawn a dividing line, roughly at the end of 2004. This happens to be where homeownership rates had peaked. Nationally, home prices had roughly doubled over the previous decade. They were within 16% of their peak. Six years later, home prices would be 14% below this level. And today, they are back to 10% above this level.

By this time, subprime originations were near their peak, as a proportion of the total mortgage market.
﻿

In other words, a large proportion of recent mortgages were subprime, and for any transaction that happened by then, almost all of the price increases were behind it, a nominal crash in home values unheard of in modern US history was in front of it, and by 2015, even after experiencing that unprecedented crash in market value, it had provided a moderate level of capital appreciation along with healthy and growing cash flows or imputed rental value.

And, yet, with all of that turmoil, the mortgages made up to that point had healthy, low default rates. Here are graphs of Alt-A default rates and subprime default rates, by vintage.

﻿
﻿

The mortgages made before the end of 2004, as a group, performed very well, despite a lot of subsequent volatility that might have caused them to perform poorly.
﻿

Even the 2005 vintage of mortgages performed fairly normally until late 2007, when home prices really began to drop. So, even the year with the highest level of subprime originations and housing starts, with homes bought at the top price of the market, were preforming within the range of the previous five years. Think about how much this contrasts with rhetoric about this period of time. These were households who, as of 2008 or 2009, were experiencing the worst home price performance of the post-WW II era, by a wide margin. They are the unluckiest set of homeowners in modern US experience, and they had used non-conventional financing at a scale far outside any previous ranges. And loan performance was normal. Even at the depth of the price collapse, the 2004 cohort was similar to earlier recession era cohorts that had experienced no price declines.

Clearly, the mortgages made before 2005 were not a part of the problem. Maybe there was rampant fraud and misrepresentation by both lenders and borrowers. But, practically speaking, just about everyone who signed on the dotted line was willing and able to make good on their financial promises. We really can say this, also, about mortgages made in 2005. But, let's say, for the sake of argument, that the eventual rise in defaults among 2005 borrowers was a time-bomb waiting to go off and that the eventual kink up in defaults on the 2005 vintage was inevitable. Here is the only part of the housing market graph above that could possibly contain any systemically important excesses. Any levels of home ownership or home values above a sustainable level have to have happened somewhere here.

Oh, and by the way, the Fed Funds Rate was above 4% by the end of 2005 and above 5% by the summer of 2006, with an inverted yield curve. None of the mortgage cohorts with high default rates were made when the Fed Funds Rate was low, and none of the mortgage cohorts originated when the Fed Funds Rate was below 2% had high default rates. So, if there was some sort of Austrian Business Cycle capital misallocation going on in 2003 and 2004, someone needs to tell the borrowers and lenders who purchased homes at the time. They may not have noticed.

If your response to this is that I am naïve - that you knew an unemployed guy who was flipping houses in 2003, that you knew a guy who worked for a predatory subprime lender in 2001 or 1996, and that they were doing terrible, irresponsible things - then you need to think about evidence, what it is, what makes it relevant, and what could possibly falsify your explanation of events at the macro level.

Here is a copy of the S&P downgrade announcement of Residential Mortgage Backed Securities on July 11, 2007. From the report:

Although property values have decreased slightly, additional declines are
expected. David Wyss, Standard & Poor's chief economist, projects that
property values will decline 8% on average between 2006 and 2008, and will
bottom out in the first quarter of 2008.
While our LEVELS model assumes property value declines of 22% for the 'BBB'
and lower rating category stress environments (with higher property value
declines for higher rating category stress environments), the continued
decline in prices will apply additional stress to these transactions by
increasing losses on the sale of foreclosed properties, as well as removing or
reducing the borrowers' ability to refinance or sell their homes to meet debt
obligations.
As lenders have tightened underwriting guidelines, fewer refinance options may
be available to these borrowers, especially if their loan-to-value (LTV) and
combined LTV (CLTV) ratios have risen in the wake of declining home prices.

And:

The loan performance
associated with the data to date has been anomalous in a way that calls into
question the accuracy of some of the initial data provided to us regarding the
loan and borrower characteristics. A discriminate analysis was performed to
identify the characteristics associated with the group of transactions
performing within initial expectations and those performing below initial
expectations. The following characteristics associated with each group were analyzed: LTV, CLTV, FICO, debt-to-income (DTI), weighted-average coupon
(WAC), margin, payment cap, rate adjustment frequency, periodic rate cap on
first adjustment, periodic rate cap subsequent to first adjustment, lifetime
max rate, term, and issuer. Our results show no statistically significant
differentiation between the two groups of transactions on any of the above
characteristics. Reports of alleged underwriting fraud tend to grow over time,
as suspected fraud incidents are detected upon investigation following a loan
default.

They seem to take the lack of explanatory power from all the typical sources of default as a sign of fraud. But, wouldn't this also be a sign that the source of the defaults is not buyer quality? If the source of stress in these mortgage pools was from some outside influence, wouldn't we still expect fraud to increase as the market distress increased and wouldn't we expect those instances where fraud was involved to be more frequently noticed (much like with S&Ls in the 1980s)? "Our results show no statistically significant differentiation between the two groups of transactions on any of the above characteristics." That is a very strong effect from underwriting fraud from a market that just 2 years prior appears to have created a cohort of mortgages that performed very well. In two years, with similar rates of originations, subprime loans went from being benign in the face of extreme volatility to being so devoid of honest underwriting that FICO, LTV, DTI, and many other reported variables had no explanatory value at all? And the fraud was so universal that even the issuer wasn't explanatory? Fraud somehow meant even the terms of the mortgages weren't explanatory?

Also, note that at the time this report was published, home prices had basically been flat for about 18 months. There were some local markets that were dropping by then, but nationally, prices were still at the plateau they had been on since early 2006. But, S&P projects a decline in home prices of 8% nationally, and up to 22% in some areas. At a point where home price trends are still stable, they predict future price trends far outside any previous experience. This must have had a large effect on the implied value of the securities in question.

And, what did the Federal Reserve have to say about the effect of these extreme expectations of nominal collapse, when they met just a couple of weeks later on August 7?:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.
Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.
Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.
Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.

In their defense, although the minutes of the meeting mention a softening even in the jumbo loan market, at that time, mortgage levels outside the subprime market were still growing modestly. But, I wonder how much of a difference it would have made if the Fed had simply made a rhetorical statement that they didn't expect home prices to fall, or that they would expect to add liquidity if home prices appeared to begin to slide. They didn't make that statement because they had no intention of supporting nominal stability as home prices fell by nearly 1% per month for the next year. This nominal collapse, after all, was not a problem, it was the "correction" of a problem.

Saturday, January 23, 2016

Adam Ozimek has a nice post today at Modeled Behavior, discussing the discipline of objectivity. His recommendations of imagining yourself changing your mind and talking about things you have been wrong about are both difficult and useful practices to maintain.

His example of something he has been wrong about is that he was somewhat sanguine about the loss of manufacturing jobs, and that the housing bust convinced him that the shift from manufacturing has been more painful than he had acknowledged. He cites a study with the following excerpt:

….We also find that housing booms significantly reduce the likelihood that displaced manufacturing workers remain non-employed, suggesting that housing booms masked non-employment growth that would have otherwise occurred earlier in the absence of the booms… Collectively, our results suggest that much of the non-employment growth during the 2000s can be attributed to manufacturing decline and these effects would have appeared in aggregate statistics earlier had it not been for the large, temporary increases in housing demand.

So, ironically, as IW readers know, Adam wasn't wrong at all. The boom wasn't unsustainable. It didn't mask anything. The bust was avoidable and unnecessary. So, without the presupposition about the unsustainability of the housing boom, this study actually reinforces Adam's prior beliefs. The lost manufacturing employment wasn't masked by housing. It was shifted to other sectors, just as Adam would have thought.

This is what is so important about getting the housing issue right. So much new research on so many issues is built on presuppositions which are false, that this one mistake is affecting many areas of economics and finance. Since we had two housing booms - the boom with little construction and high prices, and the boom with abundant construction and moderate prices - any presumption of how prices and supply related to one another on a national level is tainted.

given
that our housing demand change measure is constructed with the assumption that there are no housing supply
shocks, it is likely an error-ridden version of true housing demand changes.

They purport to try to fix that. The statistics, admittedly, are a bit above my understanding without some assistance, but they appear to try to adjust for existing supply and demand elasticities in various cities. I think the problem this may create is that supply elasticity is not stable. In any given city, supply tends to be very elastic, up to some maximum level of bureaucratic or political ceiling, at which point it shifts to very inelastic. In Dallas and Houston, that ceiling is very high. In San Francisco, it is very low. They interpret sharp price changes in places like Phoenix as shifts in demand, so that the price changes can be attributed to demand changes, but Phoenix has had high demand for housing for decades. I think what we see in 2005 in Phoenix is probably more of a shift in demand that triggered a shift in supply elasticity.

The idea that construction employment was positively correlated to home price increases just isn't plausible, given how much of the price boom was due to cities that were extreme outliers in limiting housing supply. Outside the Closed Access cities, which had prices well beyond what we saw in other cities, the places that did see price shifts tended to be sharp, late, and temporary (2004-2005). For instance, even if we attribute the sharp rise in home prices in Phoenix in 2005 to housing demand, clearly this had little to do with construction employment and its relationship to changes in manufacturing employment, which would have been steadily shifting throughout the period. And housing starts among MSA's just didn't shift that much in relation to local price shifts.

The housing boom wasn't unsustainable. The high prices were coming from the places that wouldn't accommodate a booming construction sector. The idea that the housing boom masked manufacturing losses because of construction employment in the Closed Access cities (the red lines in the housing permits graph above) is implausible.

Adam, you weren't wrong. Maybe you should be more confident about your intuition, after all!

Friday, January 22, 2016

One running theme in commentary about the recession is that recessions after financial bubbles are more severe with slower recoveries than recessions with other causes. One reason is surely because home equity is an important source of capital for new business formation, and households lack access to that capital either because of reduced property values or strained banks.

Now, it seems to me that this is a good reason to especially try to avoid the hard landing of a bust. But, there seems to be a notion that the arrival of the bust is a necessary preventative. Bubbles will be even worse if we make them less painful.

But, this doesn't really make any sense, if you think about it. The bust is the problem. Let's say we created an economic context with less downside risk. What if that caused asset prices to reach a higher plateau, because of the way we managed the risk of supposedly overpriced assets? Would that be a problem? To the contrary, that is the definition of a developed economy! If I ask you how to tell a developed, fruitful economy apart from an undeveloped, poor economy, by describing their asset markets, your answer would be something like, "The one with less volatility and higher prices, relative to expected earnings, is the developed economy."

Exuberance and high growth expectations will manifest themselves in an equity boom, like the internet boom of the 1990s. The bust that followed that wasn't so painful, because the pain was mostly felt within equity markets, which are expected to take cyclical downside. And the exuberance led to investments in tech. infrastructure and creative destruction.

But, financial expansion usually comes through safer assets like bonds, mortgages, and houses. Growth in these areas is related to low real interest rates. Low real interest rates is a signal of broad risk aversion, not exuberance.

One response to the plea to avoid a bust is that we will just be creating a larger bubble and, thus, a delayed and larger bust. But, high home prices and low real interest rates are not a signal of cyclical complacency. These are low risk, real assets. Preference for these types of assets is a product of risk aversion.

Here is a graph comparing Home Price/Net Rent to Aswath Damodaran's estimate of the Equity Risk Premium.* Home prices tend to be high when there is high risk aversion. Relative home prices were high in the late 1970s when equity prices were low. Home prices peaked again in the late 1980s, and real home prices fell quite sharply until the late 1990s. This coincided with a period of low risk aversion and high real long term interest rates. But, those high long term real interest rates were an emergent phenomenon. They were a product of low risk aversion. They weren't a product of a forced increase of short term interest rates. That wouldn't be an effective way of creating persistently high long term real interest rates, anyway, as we have seen since 2006.

So, in the 1990s, we succeeded at moderating home prices, and we did it by allowing the broader economy to thrive, not by collapsing the broader economy.

So, the idea that nominal support would worsen the bubble is wrong. If macroeconomic and monetary support had reduced the likelihood of a bust, home prices would have fallen, relative to rents and to other assets. You pop a housing bubble by growing, not by inducing instability.

Looking at this graph, we have created an incongruity where risk premiums are still high, but home Price/Rent ratios have fallen. This incongruity has broken the housing supply market. So, now rents are climbing and those who can establish a position of real estate ownership can accrue the sorts of high rates of income that should be associated with periods of low risk aversion.

The housing "bubble" should have been "popped" by (1) allowing competing supply to enter into valuable housing markets, reducing rents, and (2) supporting a healthy and safe economy so that assets with low cyclical cash flow risks weren't so prized. The combination of these factors would have had such a moderating influence on real estate values in the costliest cities that a relatively high inflation rate would have been necessary just to mitigate the nominal losses of real estate owners. But, instead, we did the opposite of this. We tried to bring the price of real estate down by blunt force.

In the end, we actually did commit the sin that the bubble worriers were concerned about, but in the opposite direction. Instead of supporting a bubble that would have supposedly led to misallocation of resources to unneeded housing supply which would have eventually led to a collapse in rents and a related price collapse, we imposed a bust, which led to non-allocation of resources (and a clamoring for treasuries) that has led to a significant increase in rents. Now, home prices remain in check because we continue to enforce an incongruity that prevents capital inflows into housing, so we have sharply rising rents, which call for new supply, but we have removed those avenues of supply. Instead of supporting an unsustainable bubble that would have led, inevitably, to an even larger bust, we have supported an unsustainable bust that will lead to an even larger "bubble".

Note that the bust we imposed doesn't even fit the bubble narrative. Bubble worriers claimed that high prices (low implied yields) would lead to oversupply, which would drop rent cash flows, and subsequent home prices would have to fall as a result. But, if we thought that there was some lag preventing lower rents from pulling down home prices, we should have implemented policies that reduced that lag and brought down rents sooner. Instead, we imposed policies that have created high yields to housing, that only made rent cash flows go higher. Even if the 2005 housing market could be characterized as a bubble, the bust which has led so many observers to take a victory lap looks nothing like the bust that they supposed would solve the problem.

A cure for the boom needn't have had any significant side effects, but the bubble poppers cheer the imposition of side effects without bothering to create a cure. They think the side effects are the cure.

Consider the possibility that, not only were the concerns of the bubble worriers misplaced, but that there wasn't much of a demand-side bubble at all. Think of the series of costs we have imposed on American households.

We have limited entry into our most productive industries, so that many families had to move into very expensive cities in order to tap into high income careers.

In order to hedge against the rising rents in those cities, those families had to pay very high prices, relative to their incomes, in order to insure stable future housing with homeownership.

Then, we suffocated credit markets and the nominal economy until the values of those homes collapsed, creating an illiquid market for them - trapping them in their homes and leaving some of them with significant capital losses.

Then, we pushed against nominal growth so hard that many of those families faced unemployment.

Now, they couldn't sell their homes to move to new job opportunities, because their home values had collapsed, and they couldn't tap home equity in order to muddle through hard times, because the mortgage credit market had collapsed.

When they eventually lost their houses, they had to move into new homes with high and rising rents.

And, now, after all of this, because of inflation that is only even moderately high because of the ever-increasing rents we have saddled them with, the Federal Reserve is trying to slow down nominal economic growth as if their rent is rising because they have too much money.

One starts to wonder if the only reason we haven't suffered a plague of locusts is because we lack the technical ability to create it.

* I think net rent is the proper measure to use here, because it is the relevant relative measure to returns from other asset classes. But, Price/Gross rent should give a similar signal, and as we can see in this graph, it does not present a relationship that is as strong. The difference is that Price/Gross Rent wasn't so high in the late 1970s. It looks like this is because the BEA's measure of consumption of capital was high in the late 1970s. That caused my measure of net rent (which is net of consumption of capital) to be low, and the lower value of the denominator makes my measure of Price/Net Rent higher. I'm not sure why the measure of consumption of capital is the difference that causes the net rent measure to confirm my thesis better. So, there could be something I am not accounting for here.

Thursday, January 21, 2016

I.
I just came across a 2005 Economist article, with the subtitle: "The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops " In the first paragraph, it notes: "Rising property prices helped to prop up the world economy after the stock market bubble burst in 2000."

This is another idea that maybe we should reconsider. I guess the idea is that rising property prices create credit expansion. I think Scott Sumner's notion of monetary offset of fiscal policy should also apply here - monetary offset of credit expansion. And, in fact, I think in both cases, there is good evidence that the Federal Reserve has overcompensated for fiscal or credit expansion.

But, even worse, if those higher levels of credit are only being taken out to fund higher payments to real estate in Closed Access cities, then the idea that a housing bubble props up an economy is especially outrageous. Did Barbary pirates prop up the economy of Mediterranean traders?

II.

From that same article:

Interest-only mortgages are all the rage, along with so-called “negative amortisation loans” (the buyer pays less than the interest due and the unpaid principal and interest is added on to the loan). After an initial period, payments surge as principal repayment kicks in. In California, over 60% of all new mortgages this year are interest-only or negative-amortisation, up from 8% in 2002. The national figure is one-third.

This seems to confirm my suspicions. Interest only and negative amortization loans were concentrated in places like California where homebuyers were hedging against rising rents. They weren't engaging in speculative over-consumption. They were trying to get out from under the relentlessly grinding cost of living in Closed Access cities. An interest only loan is a lot more sustainable than rent that is rising 5% or more per year.

III.

Also from the article:

Even the Federal Reserve is at last starting to fret about what is happening. Prices are being driven by speculative demand. A study by the National Association of Realtors (NAR) found that 23% of all American houses bought in 2004 were for investment, not owner-occupation. Another 13% were bought as second homes.

Isn't it strange how usurious loan terms, investors, and wealthy multiple-unit owners are all taken as signs of excessive speculative demand? Wouldn't we expect to see more usurious loan terms and concentrated ownership in places with limited access and constricted supply and rising rents, too? And, wasn't less concentrated ownership also taken as a sign of excessive speculative demand, when more of the buyers were new owner-occupiers? Some of this is pieces of evidence that were taken to be evidence of excess demand, but really were just evidence of prices that were high for any reason. And some of it just seems to be collectively assuming the conclusion. Think about it, rising homeownership was a sign of excess until it peaked in 2004, then rising homebuying for investment was a sign of excess until the collapse in 2006, and now that homeownership is collapsing and institutional buying is ascendant, institutional buyers are a sign of excess. We have now cycled through all the major buyer segments, and they have all confirmed the excess demand story.

If we think about it, imagine any credit-dependent market. Imagine some supply-based cause for a price spike. Wouldn't we expect that price spike to lead to more credit expansion, realization of capital gains, and an expansion of marginal credit or questionable credit terms?

Given the rise in home prices, can we imagine any set of facts that wouldn't have been interpreted as signs of excessive speculative demand? Surely we should be able to think of something. I can think of something. It happens to be the set of facts that roughly describe this period. How will others react to my story if there is no pre-existing set of potential facts that they will accept as a means of falsification? How many observers will even accept, in practical terms, the possibility that the current consensus is falsifiable?

And, that first sentence is similar to a passage in "All the Devils Are Here" (pg. 255, hardcover) about financial analyst Josh Rosner.

In mid-2005, his sources at the Fed start telling him that rates are going to rise significantly, in no small part to "cure" the excess speculation in housing. He is soon warning clients that the housing market has peaked.

This is of a class of statements that appears to be benign or satisfying if the housing market was characterized by excessive demand, but is dark and foreboding if it was characterized by supply constrictions. Think of "The Big Short", but instead of protagonists positioning for the inevitable collapse, the story's protagonists are villains in the shadows that are becoming wildly wealthy because the Federal Reserve and banking regulators are conspiring to destroy the value of every family's home. It's basically the same script. You just have to change the musical cues. In either case, the villains would be generally accidental villains, inasmuch as they weren't attempting to create a macro-crisis.

IV.

Here is another passage from "All the Devils Are Here" (pg. 268, hardcover):

On another level, synthetic CDOs were a classic example of how things never really changed on Wall Street. The sellers of synthetic CDOs had a huge informational advantage over the buyers, just as bond sellers have historically had an advantage over bond buyers. Buying a synthetic CDO was like playing poker with an opponent who knew every card in your hand. Conflicts abounded. Those..."dumb guys"...weren't necessarily less intelligent; they were simply less plugged in...Stretching to get the extra yield that synthetic CDOs seemed to offer, lacking the clear understanding of what they were buying, they were the perfect willing dupes.

What's remarkable, in hindsight, is that despite their many advantages, so many Wall Street firms, blinded by the rich fees and huge bonuses the CDO machine made possible, duped themselves as well. As one close observer says, "There was plenty of dumb smart money."

I think this is a great example of how we have populated the conventional narrative with stock characters who operate in the service of a predestined conclusion. From within the fever of collective righteous indignation, the second paragraph here says, "This episode was so out of control, the insiders that did this to us even ended up cutting off their own noses to spite their faces. Whereas the characters serving as their victims were 'dupes', the Wall Street insiders, nonetheless, took the same losing positions, because of greed, fees, and bonuses."

But, stepping out from this fever, the second paragraph is a refutation of the first paragraph. One might imagine an author writing the first paragraph, and a skeptical reviewer responding with the second paragraph, as evidence that the first paragraph was false. But these characters and the conclusions of the narrative cannot be refuted. The rest of the chapter that these paragraphs are a part of is about how Goldman Sachs is culpable because they were taking the other side of some of these deals. In fact, the case against Goldman is that sometimes they were neutral, sometimes they were aligned with clients, and sometimes they had the opposite position, and so their interests were complicated, and sometimes at odds with their clients. But, all of these conditions are presented as evidence that Wall Street insiders were greedy and that their positions caused the collapse.

I try to imagine what outcome would be seen as a falsification of the "bankers did this to us" conclusion. I think the answer to that is that we wouldn't blame the bankers if home prices had never spiked up. The only falsification would be the lack of the event itself.

So, I happened upon this story that maybe the housing problem was a supply problem. And, after I make that case, I look at this vast literature about the role of the banks, and I think, well there is a lot here. I have to address this. But, is there any statement anywhere in the literature where someone has said, "This evidence would convince me that demand-side excesses weren't a significant cause." One would think that the fact that mortgage originators were keeping the most vulnerable tranches of the securitization cash flows, that the market for most of the AAA rated securities was the banks themselves, that sophisticated Wall Street firms were competing with "dumb money" for the synthetic CDO securities, would serve as sharp pieces of evidence against the demand-side, insider-imposed, heads-they-win-tails-we-lose version of events. But, the demand-side versions spit these facts out as part of the story without even missing a step. They just keep barreling along, as if these facts strengthen their case. Is this a reader base that I should try to engage, or that I should ignore. If I ignore it, I am speaking to an empty room. If I engage it, it seems as though I am committing the classic error of trying to reason people out of something they were never reasoned into.

Every e-mail sent by an investment banker convinced that some buyer is taking on an ill-advised position is taken as proof that they knew, as if any complex capital markets are characterized by traders who are all in one accord, who only have strong opinions when they have complete certainty. As if newspaper archives aren't littered with opinionated rants from powerful insiders who were fundamentally wrong. And, every piece of evidence of actual fraud is treated as proof of the demand-side bubble story, as if the counter-narrative has to deny that fraud ever exists, or even that it would increase during a boom. But, the point of the counter-narrative is that all of these things could be as bad as they seem. They just weren't causal. After a decade of living in an echo chamber blaring "They did this to us." can a distinction that subtle be heard?

So far, I have simply written my story, with little regard for the audience. But, to the extent that I engage with the demand-side narrative, the narrative seems to be saturated with the presumptions of its audience. The engagement would be with those presumptions. I think it is a fool's errand to engage in that way. People must be willing to self-direct toward the evidence for there to be fruitful conversation. But to not engage them will look careless and aloof.

One purpose this blog has served, for me, is a sort of public record of my thinking process, so that I can go back and uncover careless thinking or unconsciously shifting goalposts. I guess, as this housing project becomes something that might reach a broader audience, I am naturally sharing this writing process, too. Maybe, like those traders e-mailing their opinions, if I am honest enough, I can eventually provide fodder to be discredited. That was the original intention of this blog, to discredit my thinking behind poor trades in time to reverse them when readers might convince me that I was mistaken. But, now that I am engaging in public policy conversations, the motives and consequences of being discredited are more complicated. Until this record becomes grist for ad hominem, maybe it can at least help to make my story as honest and effective as possible. Advice and criticism is welcome (at least for now ;-) ).

Wednesday, January 20, 2016

I have been reading "All the Devils Are Here" and happened upon this passage (pg. 252 , Hardcover edition):

Scene 2: Fall 2006. Larry Litton is a mortgage servicer... Litton also notices that early payment defaults are soaring. The mortgage originators are freaking out and blaming him. "The WMC guys are saying 'You suck,'" Litton recalls. He remembers thinking, "Maybe we're doing something wrong." So Litton comes up with what he calls an "ultra-aggressive move": hand delivering welcome packages to new homeowners, so there will be no confusion over where the mortgage checks should be mailed. But when the Litton employees arrive at the newly purchased homes, they discover something truly startling. "My people came back and said, 'Thirty percent of the houses are vacant,'" Litton recalls. In other words, borrowers who closed on mortgages had so little means to make even the first payment that they never bothered to move in.

Just think about that last sentence for a minute. Just given this information, would any reasonable person conclude that the reason for this was borrowers who closed on a mortgage with no means for payment? This is evidence for anything but that. Borrowers with no means would move in until they were forced out, wouldn't they? Wouldn't they at least take a few months of free shelter? Have tenants or delinquent borrowers anywhere ever behaved this way? When you talk to landlords, do they say things like, "It's bad out there. When I traveled to my properties this week to collect rents, I realized many tenants had moved out, in anticipation of missing a future rent payment."? Or have you met car dealers who said, "Boy, we really need to fix our credit department. Buyers keep coming in, filling out the papers, making a small down payment, then walking out the door without the title or the keys, because they realize they won't be able to make payments."?

This is one of the struggles I have about my approach to this story. I want to get into the heads of my potential readers. But, how do I do that when practically everyone reads passages like this and nods their heads in confirmation? Should I expect them to rub their eyes and shake their heads and come out of some deep stupor? I rather expect them to react stubbornly. I would react stubbornly if I were them, because even if I might have a small, technical point about this one thing, obviously there is so much evidence of abuse that this one thing doesn't really matter, isn't there? I mean, we all know that, right?

And, then I realize that even I, on my contrarian bender, have not noticed an obvious contradiction in the standard accounts of the boom - an issue (not the first, I think) where everyone believes two things which I think are both wrong, but that, in any case, couldn't both be right at the same time. We all know that by 2006, underwriting had become so irresponsible that massive numbers of homebuyers weren't even making their first payments. We also know that by 2006, mortgage originators were back-loading the terms in their mortgage deals, so that low income households could afford houses that were much too expensive for them, with payments they could afford for a couple of years until higher payments would kick in, and that those resets created a bunch of foreseeable defaults that eventually brought down the housing market.

I supose, if we ignore the evidence that says homebuyers didn't have lower incomes during the boom, and if we ignore the evidence that says homebuyers weren't buying up to more valuable homes during the boom, I suppose there is some possible universe where both things could happen.

But, back to these potential readers. Even giving the benefit of the doubt. Presenting and accepting this statement as rationally obvious is kind of bizarre. At best, one might expect the authors to react by saying, "This is kind of strange behavior. Let's check this out to confirm our hunch." And, one might expect the reader to demand that. What's strange is that there are some academic articles on the reasons for early defaults that ask that question. But, in the popular, complete narratives of the boom, the question simply doesn't seem to have been asked. We had our devils. There were no more questions to ask, just fodder for the prosecution's case. How will people react to a surprising answer to an important question they never felt like asking?

So, we know that in late 2006, buyers started walking away from homes right out of the gate. Maybe the buyers who still remained also walked away, 2 or 3 or 5 years later when their teaser rates reset. The evidence appears to overwhelmingly support this second wave of defaults due to resets...if resets on all mortgage types in all cohorts were timed to happen around the end of 2007.

Here is a graph of Alt-A mortgage defaults from a St. Louis Fed report. Behavior is similar for prime (with lower levels) and subprime (with higher levels). In all loan types, defaults are low through the 2005 cohort. You can see when each cohort hits late 2007 by where defaults kink up.

Here is a typical news article on the issue from February 2008. This is from CNN. It is interesting how they frame the issue. They note that households are walking away from homes because they are underwater. But it is framed in terms of impending rate resets. "Homeowners are abandoning their homes and, more importantly, their mortgages, rather than trying to keep up with rising payments on deteriorating assets." Notice how an unverifiable presumption is combined with a known fact. Even in the midst of home prices declining by 1% monthly, even in an article describing strategic defaults and the correlation between negative equity and defaults, the presumption is that this is a result of poor underwriting and onerous terms.

Here is another CNN article, from later in February 2008. "Defaults are spiking well before resets come into play thanks to the lax lending environment of the past few years. Many borrowers were approved for mortgages that they had little chance of affording, even at the low-interest teaser rates ."
The subtitle: "It turns out that massive interest rate spikes aren't the problem -- many borrowers couldn't afford these mortgages even at the low, introductory interest rates." We just knew that underwriting was terrible, and when defaults for 2004, 2005, 2006, and 2007 cohorts all began to sharply rise in late 2007, that confirmed it.

One response is that this is how bubbles work. They keep sucking on fumes, pushing ahead as long as the party can last, until the bottom drops out. That could explain prices (which by now were two years past their peak). But, how does that explain millions of households with supposedly unsustainable mortgage terms managing to muck along for one, two, or three years, all defaulting at the same time, regardless of the year of origination? And, subprime originations in 2004 and 2005 were very high, but defaults were low. Originations in 2006 were very high, and defaults were high. Originations in 2007 were low, but defaults were even higher. Default rates were really not correlated with origination growth, and the ability of households to cover for unsustainable terms with refis isn't as strong an argument for the range of outcomes among these years as it seems, especially when we consider the number of cities with strong housing markets that didn't see price spikes. All of the news articles of this period are a fascinating window into the ethereal essence of information, reason, and collective story-telling. A collective presumption of knowledge creates a pretense of collective learning.

The first article also includes a mention of the Mortgage Forgiveness Debt Relief Act of 2007. This act was passed in September 2007. Normally a household would have to pay taxes on mortgage debt forgiven after a foreclosure or short sale. This act made it easier for families and investors to walk away from underwater mortgages. It was eventually extended until the end of 2013. Here is a graph of delinquencies.

We couldn't help families by supporting credit markets or stabilizing nominal home prices, because we knew that home prices were too high and mortgage underwriting was too lax. But we could give them tax relief for defaulting on mortgages. You get what you subsidize, as they say.

On the other hand, there were a number of resets that came due in 2011-2012. So, maybe there was some persistence of delinquencies related to them. But, even this seems unlikely, as both floating and fixed interest rates by that late date were far below the original levels, so that even with teaser rates, the resets should have created much less of a shock than they might have in 2007.

Added: Here is a graph of subprime default rates that I should have included.

Tuesday, January 19, 2016

Jason Schrock, the Chief Economist of Colorado Governor's Office of State Planning and Budgeting
sent along this interesting graph.

At first, the relationship seems obvious, but I think it is a bit more subtle than it first appears.

I have previously tried to look at housing expense as a function of things like population change, housing permits, and net domestic migration as a proportion of population. The problem with some of those measures is that some cities have low growth because they have dysfunctional housing policies and some cities have low growth because of some other source of stagnation.

This graph solves that problem by measuring housing affordability against (housing starts / population growth). This is interesting, because after you think about it for a little bit, there isn't necessarily a reason why this would have to be the case. The relationship must be somewhat subtle. In cities that aren't building enough new housing units, there will be behavioral and structural changes about housing usage to utilize the available units more intensively. So, I don't think this is a direct relationship as much as an indirect measure of how those secondary effects of constricted housing supply would show up in the same cities where households are bidding up the existing housing stock. But, even though it is slightly subtle, I think this tells a strong story.

Also, notice that the relationship doesn't exactly look linear. As with the other measures I have been looking at, I think there are three subgroups of cities here. There are the Open Access cities, which do not have a dysfunctionally constrained housing market, and therefore do not tend to have desperate marginal behavior that leads to more intensive usage of housing units. Among those cities, there is no relationship. The regression line is horizontal, or very slightly downward sloping. Then there are the few Closed Access cities that are simply in a class of their own dysfunctionality. Then there are a few cities that are sort of at a crossroads, that might end up as a full-fledged Closed Access city within a couple of decades if they continue to attract workers without expanding their housing availability.

I suspect that if this graph ended at 2005, there would be a few more of those in-between cities, since at the time, some cities, like Phoenix and Las Vegas, appear to have temporarily had more housing demand, either from migration from the high cost cities, or from investor activity as homeowners captured capital gains from the high cost cities and reinvested, than their local housing permitting processes could accommodate.

Friday, January 15, 2016

There are a lot of positives, clearly, in the US economy right now. We should keep in mind, though, that both bond markets and equity markets are leading indicators. Things like bank credit and labor markets are lagging indicators. I suppose trend changes in housing starts are considered a leading indicator. But, I don't think the boxing referee stops counting until you get off your knees, so housing doesn't really count as an indicator of strength.

Normally, I would be trumpeting the positive slope in the yield curve as an important bullish indicator, but I think this is off the table. The Fed Funds Rate was raised on December 16, and now I think we have a clear pattern of both long term yields and equity prices dropping. This is a clear recessionary indicator. The Fed erred. The only question at this point, I think, is how much of a contraction we are in store for while they attempt to save face.

I think if they reversed the hike soon and expressed confidence in the economy and a commitment to monetary support, we would see a continuation of the recovery. But, the longer this goes, the worse it will be.

We could also be saved by mortgage expansion, but after a promising November, closed-end real estate loans at commercial banks have flat-lined again. There is a broad consensus against supporting mortgage expansion or real estate markets or implementing any public policy that might be seen as supporting stock prices. That is a context ripe for a contraction.

The first graph here shows the evolution of the yield curve. It could be that uncertainty combined with the asymmetry caused by the zero lower bound will prevent long rates from falling much lower. And, the slope of the curve coming off the initial rise is down to about 40 basis points per year. This is as low as it has been during the entire recovery. This may be pretty close to the equivalent of an inverted yield curve at this point.

For years in the 1990s and 2000s, in a deflationary context, Japanese 10 year bonds ranged between 1% and 2%. Ten Year Treasuries are now just over 2%.

In the period where inverted yield curves signaled recessions, the inversion happened with the Fed Funds Rate above at least 5%. Here is a graph of the Fed Funds Rate and the 10 year Treasury Rate in the 1950s. Twice we had recessions without inversions. The Fed Funds Rate topped out at about 3% and 4%. The 10 year remained about 1/2% above the Fed Funds Rate.

The drop in long term bond yields and the stock market are clear symbols of approaching declines in broad incomes. This is probably not the best time to have cyclical exposure.

Thursday, January 14, 2016

One of the factors in the housing bubble that is difficult to appreciate and difficult to convincingly document is the volatile influence of rent expectations. Part of the bubble story is the expectation that there cannot be persistent excessive rent inflation because higher rents will induce new supply, eventually bringing down rents and prices. Since rational homebuyers should anticipate this, home prices that rise above the level justified by current rents, incomes, etc. are a signal of irrationality - a bubble.

Of course, there can't be a sufficient market supply response in places like Silicon Valley, San Francisco, New York City, and Boston. So, instead of creating a supply response, rising rents and prices in those cities create persistent rent inflation expectations. This leads to volatility, because the effect of changing expectations on a long-lived real asset are strong. The difference in the value of rental cash flow 40 years from now with no unusual cash flow growth vs. excess rent inflation of even 1% is large. In fact, permanent rent inflation of 4% to 5% would basically drive intrinsic home prices to infinity. Homeowners in the Closed Access cities have to deal with a sort of St. Petersburg paradox:

Question: How much is a house worth in San Francisco?
Question in Reply: How accommodative will local housing policy in the year 2040 be?

The possibility of sharp regime shifts in policy and the strong influence those future policies have on the values of properties, today, makes the values of those properties very volatile, and it also makes it easy to yell "irrational exuberance" in a crowded buyers' market, because the only way to falsify that claim is to quantify the rational expectation of San Francisco housing policy in the year 2040.

The problem is, you have to have an expectation. It is unavoidably important to the value of homes in San Francisco. This is why the scoffing dismissals of San Francisco home buyers who were expecting 10% capital gains every year are slightly off the mark. The value comes from rent. And, very small changes in rental growth create huge shifts in property values. So, what if we reframed this as a question of rent instead of property values? Would it have been crazy for San Francisco home buyers to expect persistent real rent increases of 2%? Because that is about all they needed, even at the top of the market, to justify their purchase prices.

You know where buyers don't have to worry about local housing policy in 2040? Dallas, Houston, Atlanta.

So, what is more likely? That there just happen to be rapacious, short-sighted bankers and gullible borrowers in all the places with constraints on local housing expansion? Or that constraints on local housing make rational valuations very difficult, very important, and very volatile? Certainly, pre-paying those future rents by buying the property usually requires the use of credit. Certainly, some households vulnerable to the uncertainty of rising rents will be more agreeable to some uncertainty in their credit terms. So, certainly, the extent to which a generous credit market is available will effect the ability of prices to reflect expectations. The question, then, isn't whether generous credit is responsible for rising real estate prices. The question is, "Were the expectations implied by those prices reasonable?".

Has anyone even attempted to answer that question? This is one of the illusions at the heart of the housing market "bubble" narrative. Prices can rise because of positive demand pressures or negative supply pressures. Rising mortgage levels are not a sign of rising demand pressures. They are only a sign of rising prices. But, it seems that rising mortgage levels have been taken as the sign of demand pressues. Nobody has asked the important question: "What was the correct price for homes?" It sure seems like it should be around 3x incomes and mortgage payments should be 28% or less of incomes. Those rules of thumb have worked most of the time, for a long time. But, that goes out the window when median renters in places like San Francisco are spending 40% to 50% of incomes on rent.

So, one of the problems I will have as I formalize my findings is that if I have a model that seems to show that expectations were reasonable, skeptics will say, "Who says your model is right?" And they will have a point. But show me the model that the consensus is using now! It looks to me like we've drawn a straight trend line, and when prices moved away from it, we all said, "Ah, ha! It's those rapacious bankers and irrational home buyers." I ask, what is your model? A model that can attribute anything it can't explain to irrationality and unsustainable greed, and treat that as a confirmation of the model, explains everything. It's the ultimate exercise in question begging.

Aaaaannyway.... back to the issue that motivated this post. The fact that expectations are so powerful creates a real problem for the potential to solve the supply problem.

Here is a table of home valuations, based on a very simple standard financial model of discounted future rent cash flows. Here I have based it on the present value of 100 years of rent. These valuations happen to fairly closely match valuations we see in US housing markets.
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The left column has "Open Access" assumptions. These are roughly the median US input values and home price values we see today. In the mid-1990s, net rent, in nominal dollars, was about $4,000, and median home values were about $100,000. So, adjusting rent, this also roughly describes the US housing market in the mid-1990s, before the boom. (Net rent is an approximation of rent after expenses, taxes, and depreciation.)

The next column represents base US median "Open Access" home values similar to market conditions in 2005, after real interest rates had declined from the levels of the 1990s.*

The next column represents the effect on price from a sharp rise in rents.

The next column (the middle column) reflects a city with high rents and an expectation that they will continue to rise. Adjusted for rent inflation since 2005, this column roughly approximates rent, inflation, rates of return, and home prices, at the peak of the boom in 2005, in San Francisco and San Jose.

The next column reflects a city with high rents, high expected rent inflation, and an increase back to higher real long term interest rates. This reflects the current rent, inflation expectations, and real estate rates of return, and median home price for the San Francisco-San Jose consolidated metro area.

The sharp contraction in mortgage markets has led to a divergence between returns available from home ownership and returns from real treasury bonds. If those (implied) yields converged again, I think real estate values, given current conditions, in San Francisco, would rise toward the level shown in the middle column. The middle column reflects a city with the severe building constraints of San Francisco, but with a healthy mortgage market that funds a reasonable level of housing starts, nationwide and pushes prices to non-arbitrage ranges.

OK, So what's the point of my fancy-schmancy table?

Here's the take-away. Let's start at the column where interest rates have already risen to 4% and the median home in a San Francisco-like city is worth $726,812. This is similar to today's context.

Let's say that San Francisco solves their housing problem enough to reduce rent expectations, but not enough to reduce actual rents. This is actually not a natural resting point. Stable real rents are a reasonable expectation in an open access environment, where the cost of unconstrained new building creates a stable floor under expected future home prices and potential new supply creates a ceiling. But, there is no equilibrium that would remove volatile future rent expectations while keeping rents in San Francisco at the artificially high levels of today. But, taking this as a conceptual first step, this alone would reduce home values by about 13%.

But, if San Francisco realistically solved their housing supply problem, we would expect rents to eventually revert back to "Open Access" levels. This is represented in the last (right hand) column. I have tried to use relatively conservative assumptions here. In the high-rent-inflation scenario, I limited real rents in the long-term to double their current levels. In the mean reversion scenario, I have limited real rents on the downside to a level that is still 50% higher than the US median. This is about where San Francisco rents were before the 2000s. So, even the mean reversion scenario leaves San Francisco a very expensive city. And, even in this scenario, as modeled here, it would take more than 35 years for rents to revert back to that level.

So, if San Francisco credibly solved their housing problem at the abstract policy level, even before tenants actually began to see relative rents declining, home values might decline by 50%. This is the power of expectations. I don't see any natural policy resting place between those two extremes of expectations. And, I don't see how a mitigating policy can counter that. In fact, that expected 50% decline is based on today's price levels, which I would argue have already cut home values there by about 25%. So, by undercutting the national mortgage market so sharply that it hasn't expanded in nearly a decade, we have managed to avoid less than half of the potential decline in San Francisco real estate.

The sorts of policy shifts that we have to see in our leading cities in order to take the cap off of our aggregate national growth potential, to reduce income inequality, and to stop the painful segregation of low income households migrating out of those cities and high income households migrating into those cities, will be unavoidably painful. If, in the meantime, we manage to fix our national credit and monetary policies so that we stop harming potential homeowners in Texas and Georgia, then home prices will generally rise, and eventual solutions in the Closed Access cities will be even more painful. I don't think those real estate owners generally deserve to be harmed. They played the hands they were dealt, which included the expectations created by Closed Access policies. But, I don't see how we avoid it. And, they certainly won't be getting a lot of sympathy from the broader population. It's just so easy to claim, in hindsight, that the banks and home buyers were unhinged speculators taking irresponsible bets. It will be a game of "The bankers did this to us: Round 2.", complete with grainy video footage and Stacy Keach voiceovers. And even the solution will cause the airwaves to call out, "The system is rigged!" Volatility will always be blamed on the capitalists. And, it is true that the price of San Francisco real estate is more volatile than the official price of Venezuelan toilet paper. But, at least the sound and fury would be coming from necessary solutions and not unnecessary deprivation. In a complicated world, it's probably the best we can hope for.

* Actually, some of the price levels of the mid-2000s, even at the aggregate national level, reflected some of the rent inflation expectations caused by the Closed Access cities. Rent inflation and Real Rates of Return have a similar but inverse effect. So, a 0.3% rent inflation expectation and a 3.3% required Real Rate of Return would lead to a similar valuation. In either case, a net discount - growth rate of 3%, together with median nominal rent levels at the time of around $6,000, lead to a valuation of just under $200,000, which are all in the ballpark of the measures at the time.